Nationally, long-term fixed-rate mortgages carried an average interest rate of just 4 percent, down almost 100 basis points from a year earlier. Underwritten loan-to-value ratios were relatively unchanged, but lower debt yields captured lenders’ readiness to push further against every dollar of in-place cash flow.

Sam Chandan.

The contest to acquire and fund properties was captured in lower cap rates as well as lending terms. In New York, assertive investors pushed market-average cap rates lower across the full spectrum of institutional and value-add properties. Including small assets backed by mortgages of $1 million or more, cap rates averaged 5.8 percent in the second quarter. For larger institutional-quality assets, cap rates on sales and refinancing appraisals routinely fell below 5 percent.

The recovery’s prevailing trend of declining cap rates and financing costs reflects the convergence of the apartment sector’s strong fundamentals with de minimis yields on low-risk and risk-free investments. Whereas the risk aversion implied by high Treasury prices means that capital is flowing out of riskier asset classes, apartments have risen to a privileged position and evince premiums consistent with their favorable risk profile.

While the case for apartments is observably robust, the market is hardly far-sighted in measuring and mitigating the risks attendant on current herding behaviors. Investor myopia and an ingenuous adherence to textbook doctrines of market efficiency are the seedbeds of incautious decision-making. On the highest rungs of the apartment sector, the general ebullience of investors and credit risk managers is now testing the widely held notion that cap rate, debt yield and lending spreads are still wide by historic norms. Accounting for current distortions of capital and credit markets renders that claim contestable.

We can posit scenarios in which spreads will remain tight over the long haul, even if the government sponsorship of multifamily finance is ultimately less intrusive. On the other hand, we cannot reasonably project that risk-free rates will persist at crisis levels if we also believe that macro conditions will stabilize or improve. The necessary conclusion is that financing costs will ultimately rise from the bottom over the medium- to long-term investment and lending time horizon. Even if fundamentals hold up in the face of rising construction and an eventual normalization of housing market conditions, rising Treasury yields will easily dominate a further contraction in spreads. The Federal Reserve may work to moderate the increase in long-term yields, but its balance sheet is poorly matched against the combined forces of global capital flows and deficient fiscal policy.

For lenders originating fixed-rate mortgages today, exit risks will be measured in the balance of property income trends and unambiguously higher refinancing rates. Higher yields on Treasuries imply potentially extreme pressure on property values over the medium term. What does the generic calculus look like if spreads are unchanged? If Treasury rates rise to 4.5 percent, the stylized property underlying a seven-year mortgage would have to achieve 6.5 percent annualized income growth to hold its value. Lenders should take note: For a majority of assets, sustained income growth on that order renders underwriting implausible while begging for higher reserves.dsc@chandan.com

Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.